When the U.S. creates lots of money, it's just like taxation

As many observers expected, the U.S. Federal Reserve began a new round of quantitative easing this fall in an attempt to stimulate the economy by increasing the supply of available money.

As I discussed at the beginning of August, there is no fundamental difference between quantitative easing and the Fed's normal open market operations. In the latter case, the Fed buys U.S. Treasury securities on the bond market, and in the former case it buys other nontraditional financial assets. In both cases, however, it pays for these purchases by creating money.

One concern that has been voiced of late is that large amounts of quantitative easing could lead to inflation, as it might rapidly increase the money supply. When the central bank expands the money supply at the same time as the government is running a deficit, it is said to be accommodating the government, or "monetizing the debt." Economist often refer to this as an inflation tax.

To see why, consider the following example.

Suppose I showed up one morning at my Principles of Economics class with 40 dozen doughnuts. Since the enrollment in my class is roughly 240 students, this amounts to two doughnuts per student. Now suppose that I distribute the doughnuts by opening a doughnut market. I issue a total of 480 pieces of currency worth $1 each. I do so by giving two notes to each student. I then let the market clear.

As long as my students value doughnuts, the end result will be a price of $1 per doughnut and each student will receive two doughnuts.

Now imagine I decide to tax my class. Perhaps I am moving into a new house and I want to entice my neighbors into helping with the move by providing doughnuts. I figure I need 240 doughnuts to entice the right number of movers (admittedly this is a lot of doughnuts, but I have lots of heavy food storage, so it's a lot of work). There are several ways I could go about claiming the doughnuts I need.

First, I could simply confiscate the doughnuts from the students. I could threaten them all with failing grades unless they each surrender a doughnut they have just purchased. As long as my threat is believable, I will collect the needed 240 doughnuts this way. However, I will probably have a large number of very angry students as a result.

Another approach would be to confiscate a dollar from each student before the doughnut market opens. This would leave each student with $1, and I would have $240. Again, the market price would end up being $1 per doughnut, but I would end up owning 240 doughnuts and each student would have one.

This is exactly the same result as simply confiscating the doughnuts. It might be a bit less painful for my students, but it would still engender a great deal of ill feeling. I would have to threaten them in this case, as well, in order to have them surrender the dollar of currency to me.

A third approach is a bit less painful, however. Rather than take money from my students I could simply create new money. Suppose I printed an additional $480 in currency and held it myself. When the doughnut market opened for business, I could bid for doughnuts along with the students. The end result would be a market price of $2 per doughnut. Students would use their $2 to buy a doughnut each, and I would use my money to buy 240 doughnuts. Again the result is the same as if I had taxed my students one doughnut or $1 as above.

However, in this case I have not directly threatened anyone. I have simply devalued my students holdings of cash by printing more money.

Since monetizing the debt is less ham-fisted than taxation, it is often a preferred by governments. However, it does lead to higher prices and yields the same results as an outright tax.

For this reason, societies that wish to avoid high inflation rates often try to ensure the central bank is insulated from political pressure from the government. Central banks that are more independent from their governments have a much better track record of controlling inflation because they are not under heavy pressure to monetize the government's debt.

Many Fed watchers are concerned that large amounts of quantitative easing will yield a de facto inflation tax. The concern is not that the Fed is being pressured into creating large amounts of money. Rather, it is that in an attempt to stimulate the economy, the Fed will create more money that it can easily withdraw from circulation at a later date.

If this happened, the result would be high inflation rates and a drop in the value of money holdings. The government would repay its bonds with money that would be worth substantially less than when it was borrowed.